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A Dimming Outlook for Bonds May Require Some Rethinking

FOR three years, the warnings that bonds were primed for a downfall smacked of crying wolf. Bond funds generally did just fine, thank you. That is, until May.

Suddenly, we got an early whiff of what may be ahead. During that month, the mere prospect that the Federal Reserve would consider winding down its huge bond buying program caused the 10-year Treasury note yield to rise by half a percentage point. Because the price of bonds falls as rates rise, that resulted in a negative 3.7 percent total return. In June, by the same measure, the 10-year note lost an additional 2.7 percent. (Total return is the combination of the income a bond fund generates and the price change in its underlying bonds.)

Now peek at your midyear portfolio statement. Chances are good that your core bond fund is beginning to live down to expectations. The Barclays Aggregate bond index lost 2.4 percent in the first half of 2013. For the 12 months through June, the loss was 0.7 percent.

“We’re at the change point where it’s no longer about making money, but preserving capital,” said Christopher Vincent, head of fixed income at William Blair & Company.

And this isn’t expected to be just a pause before the good times return. “The pattern of bond returns over the past 12 months is what investors should expect for the next 12 months,” said James Kochan, chief fixed-income strategist at Wells Fargo Funds Management.

You say you’re in it for the longer term? Well, don’t get your hopes too high.

In a research note, Vanguard said that with interest rates starting from such a low point, pragmatists would be wise to expect their core domestic bond portfolios to earn no more than 2 percent a year over the next decade. It added that “the risk of a negative annual bond return over the next several years is elevated.”

That hasn’t happened since 1999, when the Barclays Aggregate index fell 0.8 percent. In 1994, it fell 2.9 percent.

With two-thirds of the Barclays Aggregate now stuffed with Treasuries and other government issues that are among the lowest-yielding securities, investors continue to pile into bond funds that traffic in the less pristine pockets of the market.

Last year, classic high-yield or junk bond funds, which invest in securities rated below investment grade — and, in return, generate higher yields — took in more than $23 billion in new cash, according to Morningstar. In the first five months of this year, bank loan funds, which are just another type of junk bond fund, had net inflows of nearly $25 billion.

Kathy Jones, fixed-income strategist at Schwab, does not oppose broadening a portfolio to include more than the government fare inside core bond funds. “Diversifying a little bit of your bond portfolio away from the Aggregate makes sense,” she said, referring to the index. “But we’re not advocating running helter-skelter away from the Agg.”

For starters, the cacophony of dire warnings for high-quality issues could use some perspective. The current duration for the Barclays Aggregate is about five years, meaning that if rates were to rise one percentage point, the price of the index would fall 5 percent. Total return would be better because the income component — 2.4 percent for the index as of June 30 — is added back into the equation.

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Kathy Jones, a strategist at Schwab, says she doesn’t oppose broadening a portfolio to include more than the government fare inside core bond funds.Credit
Lee Celano for The New York Times

In 1994, the Federal Reserve surprised the markets with a succession of rate increases that pushed up the 10-year Treasury yield by two percentage points. The Aggregate index lost 2.9 percent that year. That moderate decline was mitigated by the index’s higher income cushion at the time — and by the fact that the index was not as dependent on rate-sensitive government issues as it is today.

“Even if you were to see double the 3 percent decline of ‘94, you’re not talking the sort of loss you can have from other types of bonds,” said Mr. Vincent at William Blair.

One fact can become lost in discussions criticizing the Aggregate index: the alternatives carry risk, too. Because no matter their packaging, junk bonds can swoon like stocks in down markets.

For example, funds that invest in bank loan securities have been a bond marketer’s dream. These securities have floating rather than fixed rates. As rates rise, the pitch goes, so will their yields, protecting investors from the price losses that come with fixed-rate securities. But in rough economic markets, investors are likely to be burned. In 2008, an index of bank loan issues lost 29 percent, while the Barclays Aggregate gained 5.9 percent.

“Bank loans look good in the medium term, but the market has gotten ahead of itself,” Ms. Gaffney said. One reason is that bank loan bonds are tied to short-term rates, which are not likely to change much until at least the end of next year.

Not only is the floating-rate feature unlikely to kick into action soon, but the influx of investor money has pushed down yields. The yield of the PowerShares Senior Loanexchange-traded fund, which invests in the sector, declined to 3.7 percent by the end of June from more than 5 percent a year earlier. At Eaton Vance, Ms. Gaffney says she has recently been reducing her portfolio’s bank loan holdings.

The same yield compression has until recently made high-yield issues less compelling. An index of junk bonds that had a yield above 8 percent in early 2012 was below 5.5 percent earlier this year, though it ended June near 7 percent.

Tom Atteberry runs the FPA New Income fund with a stated goal of never producing a negative annual total return. Despite that high safety bar, Mr. Atteberry in years past has had as much as 20 percent of his portfolio invested in junk bonds.

A month ago, he wasn’t interested in junk issues. “I focus on risk; junk has equity-like risk, and these low yields are not compensating me for taking stock-like risk,” he said during the first week of June. But rising yields throughout the month — as other bond managers were under pressure to sell to meet redemption requests — were an “opportunity to nibble,” Mr. Atteberry said last week. Short-term junk bonds now make up 7 percent of the FPA fund’s portfolio.

Rick Ferri, founder of Portfolio Solutions, an investment advisory firm that manages $1.3 billion, continues to take his same measured approach to bonds, keeping 60 percent of the fixed-income piece of the allocation pie tethered to the Barclays Aggregate, with the remainder split between the diversifying hedges of high-yield corporate bonds and Treasury inflation-protected securities, or TIPS.

”Who cares if you earn just 2 percent or even a small negative return over the short term when rates rise quickly?” he asked. Bonds, he said, are an antidote to a falling stock market. “Remember what your bonds are for,” he said. When the stock markets “are down 20 percent, 30 percent or 40 percent, a high-quality bond portfolio will keep you from panicking.” And if you think cash is a better alternative, today’s measly savings or money market rates mean that you also get a negative return after factoring in inflation.

If any junk makes you queasy, but you still want to reduce your dependence on the Aggregate index, Ms. Jones of Schwab recommended investing part of your core portfolio in high-grade corporate bond funds with durations of about five years. “You can add one percentage point or more in yield without taking on much more risk,” she said.

A version of this article appears in print on July 7, 2013, on page BU15 of the New York edition with the headline: A Dimming Outlook for Bonds May Require Some Rethinking. Order Reprints|Today's Paper|Subscribe